Sunday, January 17, 2010

Financial market review - foreign exchange

Sterling ended among the best performers of G10 currencies this
week, logging gains of 1.6% vs the Swiss franc, the Norwegian Krone and
the euro. €/£ tumbled to a 4-month low of 0.8810 (£/€ 1.1350) after
concerns flared up over the deterioration of public finances in Greece,
and BoE MPC member Sentance hinted that he could vote for a pause in QE
in February. The USD was under pressure for most of the week but
managed to recoup some losses on Friday when a 1% drop in US equities
triggered safe-haven flows and profit taking in high yield and
commodity currencies. The Brazilian real dropped 2.6% vs the USD and
3.9% vs sterling. GBP/ZAR firmed 2.1% as gold retreated below $1,130.

A 5-day winning streak for GBP/USD pushed the cross to a 1.6355
high on Friday, before easing back on profit taking and a minor
flight-to-quality bid on lower equities and weak US economic data.
Doubts that the bounce in Q4 US GDP can be sustained into the early
part of 2010 caused equity benchmarks to retreat off their highs and
sparked a round of profit taking in the AUD, CAD and NZD which have all
done very well since the start of the year. AUD/USD moved through
0.9300 this week, supported by strong Australian employment data and a
widening in AU/US 2y rate differentials to 361bps. With a 25bps rate
hike priced in for the RBA rate meeting in February, speculation could
intensify of a larger 50bps hike if Q4 inflation data surprises to the
upside next week.

GBP/EUR posted four successive days of gains, clearing key
technical levels that could translate into further gains in the week
ahead. MPC member Sentance set the ball rolling on Tuesday when he said
that the time may have come for the BoE to adopt a wait-andsee approach
in February. MPC colleague Barker sounded a less hawkish note on
Wednesday and said that UK economic growth in the first half would be
very patchy, but that conditions would improve in the second half of
the year. The ECB decision to keep rates at 1.0% and put Greece on the
spot with regard to its public finances put the euro under pressure and
helped GBP/EUR to extend to 1.1350 on Friday, the highest since last
September. EUR/JPY dropped back below 130.50 and could threaten to
break below 130.0 if appetite for the euro continues to wane. GBP/ CHF
also did well this week by firming to 1.6756.

The decision by China to increase commercial banks reserve
requirements by 0.50% from January 18 caused only a minor blip on the
radar, but could be a hint of more policy tightening ahead in the
Chinese new year (starting February 14) as officials try to rein in
speculative excesses and rapid credit growth. USD/CNY 12-month forwards
strengthened a touch to below 6.60. The Brazilian real fell to a 3-week
low on data showing foreign portfolio outflows and speculation that the
Treasury will buy USD to curb real strength. GBP/BRL rose to 2.8963, a
one-month high.

Interest rate market review - bonds, cash and swaps

Government bonds rose for a second successive week and yields fell
back to late December 2009 levels, led by weaker economic data from the
US and confidence that G7 central banks will keep interest rates low.

Strong demand at US Treasury auctions, declines below key technical
levels and stagnating equity markets were credited for the
follow-though drop in yields. The US outperformed the UK and the EU,
with US 2y yields falling back below 0.90% and 5y swaps dropping below
2.75%, causing UK/US and EU/US basis spreads to widen. Greek 10y
spreads over bunds resumed their widening trend on concerns over the
country's deteriorating public finances.

UK data releases had no major impact on gilts this week as markets
paid close scrutiny to comments by MPC members Sentance and Barker. Mr
Sentance's comments were hawkish and hinted at his preference to pause
asset purchases at the February MPC meeting. By contrast, Kate Barker
sounded dovish and said that growth would be quite patchy in the first
half of 2009, though would strengthen in the second half. The jury is
out on what the MPC will do next, but the release of the January MPC
minutes next week should give us a better understanding of the Bank's
latest assessment. Data wise, the BRC reported an annual 4.2% rise in
like-for-like sales in December, the strongest result since April. A
decline in the RICS house price balance in December to 30% vs 35% and
weak manufacturing output data weighed on yields and dragged 5y swaps
below 3.20% for the first time since December 22. The NIESR reported on
Wednesday that the UK economy grew by 0.3% q/q in Q4 2009. The first
official ONS release is due at the end of the month. A big week lies
ahead and will feature releases of December CPI and labour market data,
and the January MPC minutes. 5y swaps ended the week down 13bps at
3.20%. 3-month libor was unchanged at 0.61%, causing a flattening in
the spread with 5y swaps to 259bps.

US government bonds had their best week since November, supported
by a number of elements including dovish comments by Fed member Dudley
(interest rates to stay low for 'at least 6 months'), weak December
retail sales and softer than expected headline CPI inflation data.
Treasury auctions including 3y, 10y, 30y paper were all very well
supported, drawing strong participation and overseas bidding. The Fed's
Beige Book reported further falls in lending and deteriorating credit
quality. A fall in US equity indices on Friday helped 2y yields to
extend below 0.90% and 10y yields below 3.70%, leaving the yield curve
very steep around 280bps. 5y swaps ended the week down 16bps to 2.71%.
Fannie Mae, Ford and Pepsico were among the biggest corporate USD
issuers.

In the eurozone, the ECB kept interest rates on hold at 1% and
refrained from making forward looking statements, sticking by its
projection for growth and inflation published last month. The ECB
intensified pressure on Greece to bring public finances in order, but
this did not soothe interest rate markets as Greek 10y yields surged
through 6.10%. Germany 2009 GDP data was a tad weaker than expected and
tempered optimism for a stronger pick-up in 2010. 5y swaps closed the
week down 10bps at 2.64%. Heavy sovereign supply from Germany was
comfortably digested this week. France will sell as much as 12bn euros
next week.

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